- Evolutionary human science suggests that it makes sense to overestimate the likelihood of rare bad outcomes
- This kind of ‘irrationality’ could have sound evolutionary underpinnings
Evidence in favour of portfolio diversification may have come from an unexpected place: the sphere of evolutionary human sciences.
The 2020 research comes from Michael Holton Price of the Santa Fe Institute and James Holland Jones of the Stanford University Department of Earth System Science. Using the brain’s evolutionary history as a starting point, the academics argue that our tendency to overestimate the likelihood of rare bad outcomes isn’t down to irrationality – it might actually have solid evolutionary underpinnings.
It has long been recognised that humans have a shaky grasp of risk and reward. What’s more, we are ‘bad’ at calculating the expected payoffs resulting from our choices. The Allais Paradox, named after an 18th century French economist, set out that people generally show inconsistent attitudes to gambles in risky situations. To test this, behavioural economists Daniel Kahneman and Amos Tversky modelled the paradox as a game – shown in the table, below.
When playing Game 2, many participants chose the second option – yielding a slightly higher chance of walking away with nothing, but a slightly higher payoff if they win. Based on their decision, we might characterise these players as ‘risk loving’ – yet they often make an unexpected decision when it comes to playing Game 1.
Crucially, Game 1 offers players a ‘certainty option’, whereas Game 2 carries the risk of walking away with nothing whichever option they choose. Kahneman and Tversky found that in Game 1, players opted for certainty over the chance of a slightly higher payoff – contradicting the choice they made in Game 2. They called this inconsistent attitude to risk the ‘certainty effect’.
It can be easy to beat ourselves up over this ‘irrationality’. After all, expected utility theory tells us that economic actors should behave quite differently: weighing the probability of an event along with the payoffs that result, and choosing the course of action with the highest expected payoff. Although behavioural economics challenges this model, the idea of people as rational ‘utility maximisers’ still lingers in economics and financial markets today.
But Jones and Price argue that there is good reason to favour certainty: you don’t want to run the risk of “going extinct”. Their research sets out that the human brain evolved to deal with variables like temperature and rainfall, which often proved high stakes: one heatwave, cold snap or drought could leave a household starving – or worse. Jones argues that “any time where you have to avoid zero, pessimism will pay off, because you’d rather leave money on the table than run the risk of going extinct”. In these contexts, boom times won’t compensate for a deadly bust.
Although dramatic, this has some interesting implications for investors, too. It reaffirms the sense of keeping an ‘emergency balance’ in cash, and can even explain the pre-pandemic popularity of negative yielding bonds. Although both provide a negative real return, they do ensure that a portfolio won’t reach extinction and hit ‘financial zero’.
The researchers also note the interesting consequences for development economics. Jones and Price highlight that subsistence populations can be slow to adopt policies designed to improve their standard of living, with take up of microfinance initiatives and new farming practices often lagging.
Jones argues that “there is an inclination to think of the poorest people as being ‘natural entrepreneurs’ because they have nothing to lose economically” – but the opposite could be true. According to the sort of evolutionary logic Jones and Price employ, it makes sense for very poor people to be especially risk averse. Jones notes that not only do “the poorest of the poor have everything to lose”, they are closer to losing it than better off people, too.
